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Public, Private Real Estate Split the Best Shot at Lowering Risk

National Association of Real Estate Investment Trusts says two decades of actual performance data show that the optimal diversification for a pension fund came from a real estate portfolio with about two-thirds private real estate and one-third REITs.

The California Public Employees Retirement System
(CalPERS) made headlines in February when it decided to focus
at least 75 percent of its $16 billion real estate portfolio on
core properties. But a new study suggests that a core-focused
approach fails to provide risk-reducing diversification for
pension funds.

Pension funds have tended to say, The losses in
opportunistic funds and value-added funds were horrible.
Lets get out of them and put all our real estate money in
core funds, says Brad Case, senior vice president,
research and industry information at the National Association
of Real Estate Investment Trusts (NAREIT). That will not
reduce risk. The only way you can do it is to combine private
and public real estate holdings.

Part of it is that despite the fact that REITs have
been around since the early 60s, it is only in the past 10
years that we have had the depth in the market that pension
funds need, in terms of being tradable, says Anatole
Pevnev, a principal at real estate investment consultant The
Townsend Group. It is just becoming a more mature asset
class.

Also, private real estate traditionally has a very low
correlation with public equities and debt, Pevnev says.
From a pension fund perspective, that is very
attractive, he says. And the returns long term are
in the 8 percent to 10 percent range, which is right on target
with a lot of the actuarial returns assumed by these plans. The
tradeoff is that you do not have access to the capital whenever
you want it. On the flip side, some pension fund
executives cite as a negative that liquidity does result
in greater volatility for REITs, he says.

Case agrees that some pension fund executives may see REITs
as more volatile than private real estate, but he says that a
closer look at the numbers disproves that idea. The
short-term correlation between REITs and the stock market is in
the 52 percent range, and for longer holding periods of two
years or more, it goes down to 40 percent he says.
Private-property values have a very low correlation when
you look at one quarter, but over holding periods of two years,
it goes to 40 percent.

The diversification benefit stems from REITs moving
differently than private real estate in the real estate cycle
for both downturns and recoveries, Case says. In the last
real estate market cycle, REIT returns peaked approximately one
year ahead of those of private real estate funds, the
paper says. REITs also began their bull market
approximately three years ahead of private funds.

No matter how you invest in real estate on the private
side of the market, the assets move in a certain cycle,
Case says. They move together, pretty much nationwide,
and pretty much for all property types. If you put a
substantial percentage of the allocation on the public side,
the returns will follow the real estate cycle, but with
different timing, smoothing the returns of the overall
portfolio.